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DEMAND ONE OF THE KEYS OF CAPITALISM WHAT IS DEMAND? • Demand is the willingness and ability to buy a product. • It is both a microeconomic and macroeconomic concept. • Introduction to Demand • Demand Schedule for Infiniti Automobiles • Price (x 1000) Quantity Demanded (x 1000) • $ 75 5 $75 DEMAND CURVE • 70 8 • 65 15 A (60, 20) • 60 20 • 55 27 • 50 38 price • 45 80 B ( 30, 200) • 40 90 • 35 130 • 30 200 • 0 INF 0 • QD 200 LAW OF DEMAND • As price increases, demand decreases. As price decreases, demand increases. • In economic terms: the quantity demanded of goods and services varies inversely with its price. • Foundations for the Law of Demand • The Law of Demand has been proven in almost all studies. • Price is an obstacle which discourages consumers. • It is also demonstrated every time a store has a sale. • Fallacies concerning the Law of Demand • 1. “Change –over-time” fallacy • 2. Paradoxical Demand Theory “NON-PRICE” FACTORS THAT HAVE AN EFFECT ON DEMAND • • • I. CHANGE IN THE QUANTITY DEMANDED: (demonstrated by different points on a demand curve) – 1. Diminishing marginal utility – 2. The Income Effect • Massive lay-offs, or increase in aggregate income (BMW or Boeing) – 3. The Substitution Effect • A lower price for one product could effect the QD for a similar item (CHICKEN---BEEF) II. CHANGE IN DEMAND: (demonstrated by a shift in the entire curve at the same prices) – 1. Consumer Income • Change in the inflation rate., new factory moves to an area or one closes down – 2. Consumer tastes • Things go in and out of fashion (tastes and preferences), or something new has been invented or developed. – 3. Substitutes • Butter and margarine, or “name brand” v. generic – 4. Complementary Items J P • Peanut butter and jelly B – 5. Change in Expectations • Outlook toward the future. If future looks good demand increases, snowstorm forecast results in a short term increase in the demand for bread and milk. – 6. Number of Consumers • Increase in retired people in an area will increase the demand for retirement facilities. EFFECT OF SUPPLY, DEMAND AND PRICE ON THE MARKET ELASTICITY OF DEMAND • How sensitive is demand to a change in price? • The demand is elastic when a change in price causes a relatively larger change in quantity demanded. – • • Jewelry, clothing, vegetables, ice cream, meat, coffee, sugar The demand is inelastic when a change in price causes a relatively small change in the quantity demanded. [But the market must be noted—is it nationwide or local] – Gasoline, bread, milk, salt, medical services, candy • Demand is unit elastic when there is a one-to-one (proportional) change in demand based on price. • • • • • • • Total Receipts Test for Elasticity: Formula Compare Total Receipts of pt. A with pt. B TR= P X QD If P and TR move in the same direction the product is inelastic. If P and TR move opposite then the product is elastic. If change in P results in no change in TR then the product is unit elastic. • CALCULATE THE ELASTICITY OF DEMAND: 7 P 6 A 5 P R I C E B 4 5 R 4 I 3 B C 2 3 E 2 1 1 0 0 1 2 3 4 5 6 7 8 9 QD/QS A 1 2 3 4 5 6 7 8 9 Qd/qs • What determines demand elasticity? • 1. Can the purchase be delayed? – If the answer is no, the product tends to have inelastic demand – Tobacco products, insulin, necessities, gas on the interstate • 2. Are adequate substitutes available? – If there are adequate substitutes, then the demand is elastic. – Gas in general appears to be inelastic, but on the local level it is elastic because of all the gas stations to choose from • 3. Does the purchase use a large portion of income? – If the answer is yes, the product tends to have elastic demand. – Cars, appliances. Exceptions: medical services SUPPLY PRODUCER CONSUMER • WHAT IS IT?? LAW OF SUPPLY • • • • • • • • The amount supplied of a product increases as price increases. • The Supply Schedule Price Quantity Supplied $30 350 25 305 20 235 15 140 10 60 5 0 • SUPPLY CURVE CHANGE IN THE QUANTITY SUPPLIED • Quantity supplied is the amount that producers bring to the market at any given price. • Factors that cause a change in supply: • • • • • • 1. cost of inputs (raw materials) 2. productivity levels (lack of or increase in technology) 3. taxes and/or the level of government subsidies 4. Number of Sellers 5. Future expectations – Price of oil increasing – Bad forecast for wheat—affect bread producers 6. Government regulations – Govt. mandate 45 mpg by 2015 – Carbon emissions reduction by 50% by 2020 Decrease In supply Increase in supply • ELASTICITY OF SUPPLY – Elasticity of Supply is a measure of the way quantity supplied adjusts to a change in price – Elastic= small increase in price—large increase in supply – Inelastic= small increase in price—little change in supply – Unit=change in price results in a proportional change in supply. Chan In the Quan suppl DETERMINANTS OF SUPPLY ELASTICITY • • 1. If companies can respond quickly to an increase price then the elasticity of supply is elastic. – Usually they are products that are relatively easy to produce.— candy, paper products, etc. 2. Conversely, if a product takes longer to produce or is more difficult to make it is more likely to have inelastic supply.—drilling for oil, making more cars, high tech products., consumer durables, food. – Things like substitutes, delay of purchase, % of consumer income have no bearing on the elasticity of supply—it is purely price. • THE THEORY OF PRODUCTION • • Deals with the relationship between the factors of production and the output of goods and services. This theory is based on the short run and only one variable changed [ labor], and not on the long run—where all the factors change. LAW OF VARIABLE PROPORTIONS This law states that in the short run output will change as one input is varied while the others are held constant. How is the output of the final product affected as more units of variable of input or resource are added to a fixed amount of other resources? (EX)--Farmer changing the brand of fertilizer used while all other factors of growing a crop stay the same.—What will the result be?? THE PRODUCTION FUNCTION This an illustration of the Law of Variable Proportions. Figure 5.5i Stage 1= # of workers increase for better efficiency. Marginal product increases. Stage 2 Stage 2= Marginal product continues to Diminishing rise as new workers are added but not lreturnsl Negative Returns by as much. Output has reached the point Stage 3 of diminishing returns. Stage 1 Stage 3= Here marginal product becomes negative and the total output decreases. COST, REVENUE AND PROFIT MAXIMIZATION • MEASURES OF COST: • 1. Fixed Costs – These are costs one pays whether a product is being produced or not. – Overhead – Salaries for “salaried” personnel, interest on bonds, rent or mortgage payments, property taxes – Depreciation • 2. Variable Costs – Wages for hourly employees – Utility costs – Shipping costs • 3. Total Cost – The total of fixed and variable costs • 4. Marginal Costs – This is the cost of the “extra” workers hired to produce additional products. VC divided by Marginal Product = marginal cost – #Wrks MEASURES OF REVENUE • • PRODUCTION, COSTS AND REVENUES: COSTS REVENUES PROFIT PRODUCTION SCHEDULE # WRKERS TOT PROD 0 1 2 3 4 5 6 7 8 9 10 0 14 42 75 112 150 180 203 216 207 190 MARG FIXED VAR. TOT MARG. TOT MARG. PROD COSTS REV REV 0 14 28 33 37 38 30 23 13 -9 -17 70 70 46 70 92 70 138 70 184 70 230 70 276 70 322 70 368 70 414 70 460 70 116 162 208 254 300 346 392 438 484 530 -3.29 1.64 1.39 1.24 1.21 1.53 2.00 3.54 --------- 0 28 84 150 224 300 360 406 432 414 380 -2 2 2 2 2 2 2 2 2 2 TOTAL PROF. -70 -88 -78 -58 -30 0 14 14 -6 -70 -150 TERMS: TOTAL REVENUE= TOTAL PRODUCT SOLD X AVE. PRICE PER UNIT. MARGINAL REVENUE= PROFIT MADE OFF THE SALE OF EACH UNIT. TOTAL PROFIT= TOTAL REVENUE-TOTAL COST 1 2 3 APPLYING COST PRINCIPLES • COSTS OF A SELF-SERVICE GAS STATION (EX) – 7 GAS PUMPS (6 gasoline and 1 diesel) – 1 WORKER PER SHIFT, IN SMALL ENCLOSED BOOTH • HIGH FIXED COSTS • RELATIVELY SMALL VARIABLE COSTS • RATIO OF FIXED TO VARIABLE COSTS IS LOW • STORE PROBABLY OPEN 24/7/365 • COSTS OF INTERNET STORE (EX) INDIVIDUAL LOW OVERHEAD WEB ACCESS E-COMMERCE SOFTWARE LOW INVENTORY SPECIALTY WAREHOUSES SHIP THE PRODUCT • Marginal Revenue = the change in total revenue divided by marginal product. • Marginal analysis involves comparing the costs and benefits of decisions that are made in small incremental steps. • Break even point is the total output the business needs to sell in order to cover its total costs. • Adding the 8th worker is where the total profit begins to drop. • The profit-maximizing quantity of output= marginal cost and marginal revenue are equal. • THE PRICE SYSTEM AT WORK • Price Adjustment Process: The market is voluntary, and benefits both. • • • • • • • Price $1.50 1.25 1.00 .75 .50 .25 Q. demanded 50 75 110 115 130 200 • Q. Supplied Surplus/shortage 150 +100 140 +65 120 +10 115 ___ 100 -30 75 -125 DEMAND AND SUPPLY CURVES EQUILIBRIUM • • • • • • • • • MARKET EQUILIBRIUM – A SITUATION IN WHICH PRICES ARE RELATIVELY STABLE AND THE QUANTITY OF GOODS AND SERVICES ARE EQUAL TO DEMAND. SURPLUS – QUANTITY SUPPLIED IS GREATER THAN DEMAND. SURPLUSES FORCE PRICES DOWN. SHORTAGE – QUANTITY SUPPLIED IS LESS THAN DEMAND. SHORTAGES FORCE PRICES UP. EQUILIBRIUM PRICE – THIS IS THE PRICE THAT “CLEARS THE MARKET” BY LEAVING NEITHER A SURPLUS NOR SHORTAGE AT THE END OF A TRADING PERIOD. • THE COMPETITIVE PRICE THEORY PRICES CAN VARY BECAUSE OF: - ADVERTISING - LOCATION (GAS STATIONS). - FUTURE EXPECTATIONS BUT PRICES TEND TO BE REASONABLY COMPETITIVE. THE MARKET ECONOMY “RUNS ITSELF”. EQUILIBRIUM PRICE Decrease in supply results in a shortage, which forces prices up. Change In Supply D1 S2 Increase in demand has resulted again in a shortage which has forced prices up. Change In Demand S1 D2 S1 D1 x x x x D1 S1 D2 X x Decrease in demand has resulted in a surplus of supply therefore forcing prices down.